The other problem with venture capital: management fees

Bill Gurley posted a really nice summary of one of the main problems with the venture capital industry, and Fred Wilson responded here. I totally agree with their analysis, but would add one more major problem with the venture industry to the list. The fact that most VCs get rich via “management fees” just by showing up every day.

For those who don’t know, most VC’s get paid by so-called 2 and 20. The 2 refers to the 2% of the fund they use to cover operating expenses and pay their salaries. The 20 refers to the (normally) 20% “carry” fee – the percent of the profits they make for their investors that they get to keep.

Now I fully support carry fees – it is very similar to equity in a startup. VC’s should get paid when they make money for their investors.

The problem is the management fees. 2% made sense back when VC funds were much smaller, but not now that they have gotten so large. As peHUB said in their email newsletter today, Benchmark had an $85M fund in 1995 but today has a $500M fund. That seems to be the typical trend for most big VCs.

Let’s do a little math. 2% of $85M is $1.7M. Assuming 8 partners, that means salaries are in the $100-$200K range. Much higher than national averages but, by the standards of finance, they aren’t getting “rich.” 2% of $500 is $10M, so each partner is probably getting $1M+ in salaries. Over the 10 year life of the fund that’s $10M. Even on Wall Street that is considered pretty rich. And they get that money even if they make only bad investments and don’t return a dime to their investors.

This is why you see VCs raising bigger and bigger funds, why you frequently hear them say things like “I need to do 2 deals this year” and, worst of all, why you often see VC’s arguing for larger round sizes even if the startup has no productive use for the additional money – and even for the same percentage ownership. In other words, in many cases VCs argue for a higher valuation just so they can “put more money to work.” Why? If you raise a $500M fund and tell your LPs you are going to invest it over, say, 4 years, then its pretty hard to go back to them after a year and say “thanks for the $10M in management fees, I decided not to make any investments this year.”

VC’s seem to be a big fan of performance-based compensation when it comes to startups. They should adopt it for themselves as well.